Let’s talk a little about diversification. Do you need to diversify to reduce risk or reduce volatility?
Let’s talk about risk. Negative risk implies you lose actual money, not just market value. If you own tons of just one stock, you have a real risk that you will lose all of your money, in a very real sense. The company could go out of business, or perhaps declare bankruptcy, leading your shares to be absolutely worthless. That’s bad.
To reduce risk, we add companies. It’s as simple as that. Ten to twenty companies reduce your risk to reasonable levels. On the flip side, as you add companies you likely will reduce the growth of your portfolio.
You could also say there is a risk you make a bad move if stocks go down. Going down doesn’t lose you money, selling does. Because in the next day, week, or month your stocks could go back up to where they were before and selling is the only way you lose money in this scenario.
It’s hard to stomach the market losses but you shouldn’t put your money in the stock market if you can’t.
Now if you are going to need money from your portfolio in the next 5 years, say if you’re retired, you probably want to have a more balanced portfolio that includes fixed income as well as stock so that money is available to you. Fixed income can be something like US Treasuries.
Let’s talk about volatility. Volatility is what the market does to a company’s stock. The stock goes up, the stock goes down. The market can’t decide for sure how to value the company so there might be changes like this every single day. A high growth stock will sometimes be volatile. But if the stock is a good company, it will go up more than it goes down. How do you know it’s a good company? The things you can prove: Revenue, profit, cash, margins, growth. Facts and data. Not what you hear from other people, the things in the financial reports. You could also use intangibles, such as the track record of the CEO for example.
So you do your research and you pick a good company. The company’s market value won’t go down the day after you buy it right? Wrong, it could go down. And the closer you are to buying at a fair value, the more likely that is to happen. You can feel less foolish by figuring net present value and buying well under it.
What about macro economic factors or charts? I don’t tend to worry too much about these things, although charts can be useful and macro economic factors could be useful if you could prove what the future holds. Most of the time these things are just a lot of guess work. I’ve found one thing I like: The Buffett Indicator, which I’ll talk about soon.
I know that you can be an investor rather than a gambler. Save the gambling for the casino.